International Finance : Unit-1

International Financial Management

UNIT-1- INTRODUCTION

International Finance: Meaning – Nature - Scope – Importance – Features - Goals - IFM

and Domestic Financial Management – Role of International Financial Manager in
Multinational Corporations - Relationship between IFM and Other Management Areas –
International Financial Environment (Theory).

Unit -1 objective
To annotate the importance of international finance, its features and its relationship with the
domestic finance. Learn the nature and scope of International Finance and its relationship with
other management areas.

Outcome of Unit-1
Should be able to learn the nature and scope of International finance
Annotate the importance and features of International Finance
Identify the role of international finance manager and
Compare International Finance and Domestic finance.

Meaning of Finance

Finance is the science and art of managing money and other assets which can be classified as:

Public Finance: Managed by the government of a country to maintain all the economic activities.

Private Finance: Managed by individuals out of their income earned and expenditure incurred.

Corporate Finance: Managed by companies by raising funds and allocating them as per the
requirement of the organisation.

Aims of Finance Function

The finance function supports the pursuit of business objectives by performing number of
functions such as:
Estimating adequate funds ~ Mobilization of funds ~ Acceleration of profits ~ Financial reporting
~ Accounting and Analysis ~ Maximize firm value
Scope of Financial Management
Financial management is the process of planning, raising, controlling and administering of funds
used in the business which involves:
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Financing Decisions ~ Estimating the financial requirement and Determining the capital structure.
Investing Decisions~ Assessing risk and return and Investment of Funds
Dividend Decisions~ Management of earnings and distribution of profits
Liquidity Decisions ~ Currents assets and current liabilities management and evaluating
Liquidity vs Profitability.

International Financial Management - Meaning and Overview

International Financial Management is concerned with the management of finance in an

International Business Environment by an organisation. International finance is the study of
monetary interactions that transpire between two or more countries.It focuses on areas such as
foreign direct investment and currency exchange rates. Increased globalization has magnified the
importance of international finance. Business may take place in the form of trade which may be
imports or exports of goods and services between countries. International Trade involves
exchange of goods and settlement is done through payments of money in foreign currency.

Modes of International business

International business can be done in any one or all of the following modes namely

a) International Trade: In the form of imports and exports

b) Contractual Mode :Licensing (right to use the product by paying fees without getting
ownershiprights.)
Franchising( ownership of business by paying fees. Eg. McDonalds,
Dominos)
Management contracts and Turnkey projects.

c) Foreign Investments: In the form of FDI and FPI

Role of Multinational Corporations(MNCs) in International Finance

MNCs are a cluster of affiliated firms located in different countries that are linked through a
common ownership, draw upon a common pool of resources and respond to common strategies.
MNC or a world wide enterprise is a corporate organisation that owns and controls production of
goods or services in at least one country other than the home country. They should derive at least
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25% or more of its revenue from abroad. For qualifying as MNC, the number of countries where
the firm operates should be at least six.

MNCs are a cluster of affiliated firms located in different countries that are linked through a
common ownership, draw upon a common pool of resources and respond to common strategies.
It can be grouped as follows:

Ethnocentric - Adopts home market oriented policies

Polycentric - Follows host market oriented policies

Geocentric - Balance between home and host market policies

Features of International Finance

International Finance came into existence due to the International Business. Modes of
International Business is classified as
a) International trade which may be in the form of imports or Exports.
b) Contractual entry mode through contracts like licensing, franchising, management contracts
and turnkey projects.
c) Foreign Investments which may flow in the form of Foreign Direct Investments(FDI) or
Foreign Portfolio Investments (FPI).
Whichever is the mode of flow of finance between countries, there is always an inherent risk
involved in the foreign exchange. The features of international Finance includes risk as well as
various opportunities for the business to be established outside a home country. Since the entire
world has become a global market, the significance of international finance has increased.
The following are the features of International Finance
1. Foreign exchange risk
Exchange of currencies are inevitable in International Business. When different National
currencies are exchanged, there is a definite risk of volatility in foreign exchange rates.
The variability of exchange rate is widely regarded as the most serious International
finance problem faced by policy makers and the corporate world. During the 1970s, fixed
exchange rates were abandoned and since then there has been high fluctuation in
exchange rates.The exchange rate fluctuations will affect the profitability of Corporates
and the traders and therefore it requires a proper management of exchange rate risk.
2. Political risk
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The cross border business transactions will have the political risk because of the change
in government in different countries. The policies of the government and the actions taken
by the different government might lead to certain business loss of an MNC and therefore
the international business should consider the political risk involved in the business. Also,
countries worldwide may have a different tax regime, different laws, rules and regulations
to be followed for business. This causes political risk for an international business.
3. Expanded opportunity sets
When the firms go global, they have comparative advantage which can be utilised for
their benefit. For instance, when the cost of capital is less in a particular country a company
can raise the capital from that country so that it can increase its profits. When a large
capital is raised, it also leads to the benefit from economies of scale. Similarly, if the cost
of producing a product in a particular country is higher than the cost of importing, a country
should prefer imports rather than being indigenous. This leads to expanded business
opportunities for MNCs.
4. Market imperfections
The Global market today is highly having an imperfect competition. Each nation has got
its own Tax rules, financing rules, general laws and a different environment for business.
This will restrict the investors from having a diversified portfolio and therefore it will be
challenging for the multinational corporations and its management to take the best
possible financing decisions.

Nature and Scope of IFM

The entire gamut of financial functions related to international business forms the subject matter
of international financial management. The nature of these financial functions will lead to the
nature and scope of IFM which can be broadly classified on the basis of
i) International trade ii) Investment and financing decisions iii) Other areas
i) International Trade
International Trade involves the imports and exports of goods and services for which the payment
has to be made or received in foreign currency. The exchange of currency has led to the
emergence of a globally spread foreign exchange market which is a subject matter of international
finance.
● Exchange rate and its determination:
When currencies are exchanged in the forex market then the question of determination of
exchange rate arises. Sometimes the exchange rate between two currencies is fixed as per the
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government announcement, but most of the time the exchange rate is determined based on the
demand and supply of currencies. International Monetary Fund lays down the norms and
procedures for different types of exchange rate regimes and the member countries should follow
the rules. IMF will also do surveillance on the functioning of the exchange rate and it also helps
to maintain International liquidity to ease the flow of international Monetary transactions.Therefore
it becomes a part of international Finance.
● Exchange rate risk and its management:
Though the forex market is supposed to be perfect and where nobody should be allowed to
influence the exchange rate, it is not possible practically. The difference in exchange rates in
different markets at the same point of time will lead to the chance of making profit by the
arbitrageurs. To avoid the risk of this exposure the traders will opt for hedging and protect
themselves from the loss which may arise due to the volatility in the exchange rates. This has led
to the trading in the currency futures and currency options in the derivative market. International
Financial Management covers all these activities of arbitrage, hedging and speculation.
ii) Investment and Financing decisions.
● Cross border investment has evolved and the operation of financial companies in the stock
exchange abroad operate with the objective of maximizing gain at a given level of risk or
minimising risk with a given level of return which is an important segment for International
Finance.
● Financial activities of FDI also is a major part where IFM is involved. International capital
budgeting decisions should be taken to check the viability of a new proposal while
calculating the feasibility of the project, that is the net present value should be above zero
so that the gains are higher than the consideration paid after taking political risk into
consideration.
● Though MNCs have easy access to International Financial markets, these markets
embrace a variety of sources from International Development Banks like World Bank,
International Financial Corporations, Asian Development Bank, Regional Development
Banks etc. Whatever is the source, MNCs are careful about the effectiveness of their
funds in the form of interest rates, appreciation or depreciation of their currency and also
the weighted average cost of capital based on the debt equity norms of various countries.
● Raising of funds from different International Financial markets might not be feasible for
MNCs due to various factors. In such a case the borrower may swap the loan which may
be a currency swap or interest rate swap. In case of floating rate interest, the rate changes
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frequently and so the borrower is exposed to interest rate risk. Therefore managing this
risk is a part of IFM.
● Working capital requirement and management is another important concept where the
MNCs should concentrate when they are raising the funds and how the current assets are
going to be financed is a very important factor for the management of International
Finance. Optimization of current assets are required for the trade off between the liquidity
and profitability of MNCs.
● Special consideration should be given for the management of cash in MNCs in lieu of
large-scale intra-firm movement of cash versus the restrictions imposed by the host
government. Investment of surplus by MNCs and their cash position during a specific
period is also covered by international Finance.

iii) Other Areas covered by International Finance

● International accounting and international tax strategy of the MNCs when they consolidate
their financial statements depends on the tax rate and Tax rules of a host country.
International firms often resort to transfer pricing in order to siphon off pre-tax profit from
a high tax country to a low tax country, so that they can maximize their Global profits
.International finance deals with the above.
● Balance of payment and external indebtedness also is a part of international Finance.
Flow of funds into a country and out of a country is recorded to the debit and credit side
of a statement prepared by the government of a country called as the Balance of Payment
statement. This statement reflects the performance of countries' external sector and the
flow of funds. When there is a shortfall of inflow when compared to the outflow, then the
government resorts to borrowings which may lead to external debt and may weaken the
economy.

Functions of IFM
Basic Functions: a) Acquisition of Funds b)Investment of Funds c) Risk management
a) Acquisition of Funds
This function involves generating funds from internal as well as external sources, for instance
from International Financial Markets - Capital and Money Markets. The effort is to get funds at the
lowest cost possible.
b) Investment of Funds
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It is concerned with deployment of the acquired funds in a manner so as to maximize shareholder

wealth. Other decisions relate to dividend payment, working capital and capital structure etc.
c) Risk management
Risk management involves both financing and investment decisions.
However, Finance Functions of a MNC can be broadly classified as Treasury and Controller
functions
The TREASURY function
The treasury typically manages the firm’s cash, investing surplus funds when available and
securing outside financing when needed . The treasury also oversees a firm’s investment plans
and manages critical risks related to movements in foreign currency values ,interest rates and
commodity prices.

The CONTROLLER function

The controller typically handles the accounting activities, such as corporate accounting, tax
management, financial accounting, and cost accounting. The treasurer's Focus tends to be more
external , whereas the controller's focus is more internal.

TREASURER CONTROLLER

Procurement of funds Accounting and auditing

Banking relationship Reporting of financial information

Investor relations Custody of records

Investment of funds Budgeting

Cash management Interpretation of financial data

Credit appraisal and collections Appraisal of results

Insuring assets Preparation of taxes

Reasons for the growth of international finance or factors influencing the growth of
international Finance.
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1. Growth of international trade and domestic trade

The two most important reasons for the growth of international trade is
a) Liberalisation of trade and investment through WTO which has led to the reduced tariffs
quota, currency control and other impediments to the international flow of goods and
capital.
b) Rapid improvements in the communication and transportation sector has resulted in the
reduction of cost in various countries. This has created an unprecedented shrinkage in the
economic space which has led to the growth of international trade.
2. Rewards of international trade
International trade has brought increased prosperity by allowing Nations to specialise in
producing those goods and services where they are relatively efficient. The relative efficiency
means the capability of the country to produce a product that is an alternative with the same
inputs. It is called a comparative advantage where all the Nations can simultaneously gain from
exploiting the advantage with a broader choice of products which is possible through international
trade.
3. Risks of International Trade
There are various risks faced by exporters and importers resulting from the impact of the changes
in prices, sales and profits which is an additional risk. Despite the risk of the political social and
economic environment of different countries, international trade has grown due to the enormous
profits available for the corporations in the untapped market.
4. Increased globalisation of financial and real estate markets
There is an unprecedented growth in the money market and capital market across the world due
to liberalisation and easy flow of capital from one market to another. A few countries have also
allowed the investment by foreigners in their real estate market which has led to the globalisation
of this market too.
5. Increased volatility of exchange rates
The expanded International flow of investment has necessitated the need for International
Finance due to the flow of currencies from one country to another for the purpose of business or
trade. Movement of currency from one country to another will lead to the increased demand or
supply of a particular currency which in turn leads to volatility of exchange rates.
6. Increased importance of multinational and transnational corporations
Corporate investments across borders have grown four times faster than the Global output and
three times faster than the international trade.It is estimated by the United Nations that there were
35000 MNCs and the largest hundred firms are responsible for 16% of the world's productive
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assets constituting more than 301 trillion dollars. Their power may lead to influencing the
Government of the host country especially the smaller Nations.

Differences between International Financial Management and Domestic Financial

Management
Although both are similar to a great extent if m has a wider scope and is designed to cope up with
a greater range of complexities due to the following reasons:
i) MNCs operate in different economic, political, legal, cultural and tax environments.
ii) They operate across and within a varied range of products and factor markets which varies in
competition and efficiency.
iii) They trade in a large number of currencies and so their dependence on the forex market is
substantial.
iv) They have easy access to domestic as well as unregulated International capital markets which
completely differs in its efficiency and competitiveness.

Basis of difference IFM DFM

Political Relation MNCs operate in different since the business is done

countries which involves the within the same country it
political relation between the involves only the home
home Government and the government
host government

Capital Budgeting Allocation of resources Since the business is situated

involves the purchase of
assets including the capital
budgeting decisions. the
application of this technique
has to consider the intra-firm
flows of funds
in one Li one country the
capital budgeting decision
made not consider the flow of
funds between forms situated
in the same country

Working Capital The Working Capital As the business is situated in

Management in an MNC is
more complex because it
involves the cash movement,
raw materials and finished
goods movement from one
political and tax jurisdiction to
another.
one country, the Working
Capital Management involves
the managing of day-to-day
payments including the
creditors who have sold the
raw materials or finished
goods.

Dividend Decision Dividend decisions of MNC is As the shareholders are

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a two-step process because situated within one country

the subsidiary company where the business is done,
situated in the host country the dividend decision is
cannot take any dividend directly taken by the
decision.It will only repatriate management of the business
its profits to the home country done in the same country.
which will take a dividend
decision as the shareholders
are situated in the home
country.

Foreign Exchange Foreign exchange As only a single currency is

Management management is very crucial involved, there is no need for
for international finance foreign exchange
because it involves volatility management.
in exchange rates very often
and requires extensive risk
management of the volatility
of exchange rates.

Role of International Financial Manager in Multinational Corporations

International Financial managers have a major role in multinational corporations which are as
follows.
1. Forecasting the financial environment and estimation of finance
A financial manager is responsible for the estimation of Finance required for the organisation. For
this purpose, the requirements related to the financing and Investments should be made by the
manager which is the forecast based on the environment in which the business is done. There
are various factors which are to be taken into consideration while taking financial decisions by the
manager. For instance, the price prevailing in the Global market, the interest rates of various
countries , the inflation prevailing in various countries etc.,
2. Exchange rate risk and management
A financial manager who deals with international business should be well versed with the
exchange rate fluctuations prevailing in the market and the risk related to its management. An
International Financial manager should be able to judge the effect of exchange rate risk on the
cash flows, revenue and the balance sheet of the firm.Based on this, the manager should take
decisions related to hedging, arbitration or speculation which are the techniques / tools to tackle
the risk in foreign exchange management.
3. Management of assets.
The most important objective of a financial manager is to manage the Assets of the company that
is, the fixed assets and the current assets. The managers should be able to make a proper
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decision while buying the fixed assets by doing the cost benefit analysis and by applying the
capital budgeting techniques. Wrong capital budgeting decisions would affect the revenue of the
firm in the long run. Similarly cash management is the next important objective wherein a financial
manager should have the acumen to forecast any emergencies and set aside the reserves in the
form of cash for emergencies.
4. Management of liabilities.
A financial manager's role is very important in raising the finance for the organisation. The
financial requirement might be for short-term or long-term and the decisions of the financial
manager should be inclusive of the cost of capital before deciding the source. The finance can be
raised through bank loans, issue of debentures, equity shares or preference shares. An
international financial manager should consider the various options available in the global
financial Markets and should opt for the cheapest mode of finance.

5. Performance evaluation and control.

For any organisation the evaluation of the performance is essential. The effectiveness of the
financial manager depends upon the way he is able to evaluate and control the finance for the
organisation. The manager is also liable for the performance of the organisation and accountable
to the stakeholders and tax authorities of different countries. Since, International finance deals
with the business done in different countries the management of accounts is spread between
different countries and different currencies which has to be properly represented as per the rules
and regulations prescribed internationally.

Relationship of IFM with other branches/ management areas

International Financial Management is closely associated with various branches and
management areas which are as follows
1. Economics
Micro and macro economic factors, Economic order quantity, time value of money and discount
factor are the few areas covered and related to International Finance.
2. Accounting
Financial information of a business concern is expressed in the form of financial statements and
hence a multinational corporation also should represent its financial statements accordingly.
3. Maths and Statistics
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Tools and techniques called Econometrics are derived from mathematics. Apart from this, cost
of capital, capital structure theories, ratio analysis etc., is derived from mathematics. All these
techniques are used in International Financial Management.
4. Production and Marketing management
Operational part of a business concern which helps to multiply the profits depends upon the
production performance of the organisation. Appropriate allocation of finance for this department
helps for a smooth production activity. Innovative methods of marketing to suit the requirements
of global consumers would lead to the increase in sales and thereby the revenue of the
organisation.
5. Human Resource Management
It provides manpower to all the functional areas of management and is an inevitable part of
international finance.
6. Banking and Financial Services
One of the major sources for raising finance by MNCs for their short term and long term
requirements. Global financial / capital markets are a major source of raising finance which helps
to gain the cost advantage and the reduction in cost of capital.
7. Taxation
The tax rates of different countries should be closely followed to make the best out of different
rules. MNCs can pay the tax in the country which has got a lower taxation rate if there is a Double
Taxation Avoidance Agreement (DTAA) with that country.
8. Foreign exchange Market and management
Forex market is very crucial and closely associated with IFM. A close watch has to be kept on the
fluctuation of exchange rate in order to avoid the risks involved in forex transactions by MNCs.

International Financial Environment

Sometimes, macroeconomic events occur that cause a ripple effect throughout the international
financial environment. Even if a condition or event unfolds in a single country, the influence of that
country's economy has the potential to move the markets around the world. An international
financial environment represents the conditions for activity in the economy or in the financial
markets around the world. International financial environment is totally different from the domestic
financial environment. International financial management is subject to several external forces,
like foreign exchange market, currency convertibility, international monetary system, balance of
payments, and international financial markets.
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1. Foreign Exchange Market

Foreign exchange market is the market in which money denominated in one currency is bought
and sold with money denominated in another currency. It is an over the counter market, because
there is no single physical or electronic market place or an organized exchange with a central
trade clearing mechanism where traders meet and exchange currencies. It spans the globe, with
prices moving and currencies trading somewhere every hour of every business day. The foreign
exchange market consists of two tiers: the interbank market or wholesale market, and retail
market or client market. The participants in the wholesale market are commercial banks,
investment banks, corporations and central banks, and brokers who trade on their own account.
On the other hand, the retail market comprises travelers, and tourists who exchange one currency
for another in the form of currency notes or traveler cheques.

2. Currency Convertibility

Currency convertibility is the ease with which a country's currency can be converted into gold or
another currency. Currency convertibility is important for international commerce as globally
sourced goods must be paid for in an agreed upon currency that may not be the buyer's domestic
currency. For the rapid growth of world trade and capital flows between countries convertibility of
a currency is desirable. Without free and unrestricted convertibility of currencies into foreign
ex-change trade and capital flows between countries cannot take place smoothly.Foreign
exchange market assumes that currencies of various countries are freely convertible into other
currencies. But this assumption is not true, because many countries restrict the residents and
non-residents to convert the local currency into foreign currency, which makes international
business more difficult. Many international business firms use “countertrade” practices to
overcome the problem that arises due to currency convertibility restrictions.
3. International Monetary System
An international monetary system is a set of internationally agreed rules, conventions and
supporting institutions that facilitate international trade, cross border investment and generally the
reallocation of capital between nation states. The international monetary system refers to the
operating system of the financial environment, which consists of financial institutions,
multinational corporations, and investors. The international monetary system provides the
institutional framework for determining the rules and procedures for international payments,
determination of exchange rates, and movement of capital.
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Any country needs to have its own monetary system and an authority to maintain order in the
system, and facilitate trade and investment. India has its own monetary policy, and the Reserve
Bank of India (RBI) administers it. The same is the case with the world, it needs a monetary
system to promote trade and investment across the countries. International monetary system has
existed since 1944. The International Monetary Fund (IMF) and the World Bank have been
maintaining order in the international monetary system and general economic development
respectively.

4. International Financial Markets

International financial market born in mid-fifties and gradually grown in size and scope.
International financial markets comprises international banks, Eurocurrency market, Eurobond
market, and international stock market. International banks play a crucial role in financing
international business by acting as both commercial banks and investment banks. Most
international banking is undertaken through reciprocal correspondent relationships between
banks located in different countries. But nowadays large banks have internationalized their
operations; they have their own overseas operations so as to improve their ability to compete
internationally. The Eurocurrency market originally called the Eurodollar market, which helps to
deposit surplus cash efficiently and conveniently, and it helps to raise short-term bank loans to
finance corporate working capital needs, including imports and exports. The Eurobond market
helps MNCs to raise long-term debt by issuing bonds. International bonds are typically classified
as either foreign bonds or eurobonds. A foreign bond is issued by a borrower foreign to the
country where the bond is placed. On the other hand Eurobonds are sold in countries other than
the country represented by the currency denominating them.

5. Balance of Payments

International trade and other international transactions result in a flow of funds between countries.
All transactions relating to the flow of goods, services and funds across national boundaries are
recorded in the balance of payments of the countries concerned.

Balance of payments (BoPs) is a systematic statement that systematically summarizes, for a

specified period of time, the monetary transactions of an economy with the rest of the world. Put
in simple words, the balance of payments of a country is a systematic record of all transactions
between the ‘residents’ of a country and the rest of the world. The balance of payments includes
both visible and invisible transactions. It presents a classified record of:
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1. All receipts on account of goods exported, services rendered and capital received by
‘residents’ and
2. Payments made by then on account of goods imported and services received from the
capital transferred to ‘non-residents’ or ‘foreigners’.

Thus the transactions include the exports and imports (by individuals, firms and government
agencies) of goods and services, income flows, capital flows and gifts and similar one-sided
transfer of payments. A rule of thumb that aids in understanding the BOP is to “follow the cash
flow”. Balance of payments for a country is the sum of the Current Account, the Capital
Account, and the change in Official Reserves.

Questions
5 marks

1.Meaning of International finance.

2.Modes of International business.
3.Features of International Finance.
4.Reasons for the growth of IF.
5.IFM vs DFM
6.Functions of IFM

10 marks

1. Nature and Scope of International Finance.

2.International Financial Environment.

3.Explain in detail the functions of IFM.

4.Role of International Financial manager.

5.Explain the various functions of IFM.

6.Explain the factors influencing the growth of IFM.